Adjustable-Rate Preferred Stock (ARPS)

What Is Adjustable-Rate Preferred Stock (ARPS)?

Adjustable-rate preferred stock (ARPS) is a type of preferred stock where the dividends issued will vary with a benchmark, most often a T-bill rate. The value of the dividend from the preferred share is set by a predetermined formula to move with rates, and because of this flexibility preferred prices are often more stable than fixed-rate preferred stocks.

Understanding Adjustable-Rate Preferred Stock (ARPS)

The preferred category of stocks is often considered more secure than common shares as they will be one of the first of the equity holders to receive dividend payments in the event of the company's liquidation. There is often a limit to the amount the rate can change on the dividend, adding further security to the issue. Also, adjustable preferred shares have dividends that periodically reset to match prevailing interest rates or other money market rates, usually on a quarterly basis.

The stability of the market value of adjustable preferred stocks, with respect to dividends payouts, makes these securities extremely attractive to conservative investors who are looking for reliable income sources as well as the preservation of their capital.

Special Considerations

Adjustable preferred stocks share most of the same upsides and downsides associated with non-adjustable, or “fixed-rate” preferred stocks. In both cases, corporations must first pay out dividends to preferred stockholders, before paying out dividends to common stock shareholders. But there are some key differences between adjustable preferred stocks and their non-adjustable counterparts.

There are also some negatives ramifications associated with adjustable preferred stock dividend rates. Namely, since adjustable preferred stock dividend rates are tied to a specific reference interest rate or index when the reference rate falls, so does the APS dividend rate. Consequently, an investor would receive smaller dividend payouts, and the price of the stock shows little change with these securities, unlike fixed-rate preferred stocks, whose prices rise when interest rates decline.

Boundaries In-Place

Adjustable preferred stocks have set parameters called “collars,” which are essentially caps and floors placed on dividend yields. A floor—the minimum dividend yield an APS will payout, holds strong, even if interest rates drop below the floor figure. Contrarily, a cap limits the maximum dividend yield payout. Naturally, investors like floors and dislike caps. Adjustable preferred stocks behave similarly to fixed-rate preferred stocks when interest rates fall on the other side of the collar range.

Auction-Rate ARPS

Some adjustable preferred stocks use periodic auctions to reset dividend yield, where current and potential shareholders participate in an auction that ensures that APS dividend yields reflect the current requirements of investors. Auction market preferred stocks have interest rates or dividends that are periodically reset through Dutch auctions.

Interest-rate auctions for auction-rate securities, however, began to fail during the 2008 financial crisis. The auctions attracted too few bidders to establish a clearing rate, and these dislocations resulted in high or “penalty” interest rates on those securities and/or an inability of investors to sell their auction-rate securities.

The auction-rate securities market collapsed in February 2008 when lead underwriters chose not to step in to support the auctions. For investors, this meant that they were left with illiquid investments. Since the collapse of the auction-rate securities market, the U.S. Securities and Exchange Commission, Financial Investment Regulatory Authority, and state attorneys general have reached settlements with major broker-dealers and other entities. These settlements included agreements to buy back auction-rate securities from certain investors.